What is FX trading?

What is FX trading and can you make money from it? Rupert Hargreaves explains how it works and the risks.

FX trading
(Image credit: Getty Images)

Foreign exchange trading, or FX trading, seems to be all the rage and a fast route to riches. 

But the reality couldn’t be more different. Most so-called retail traders (those of us without millions of pounds to play with) lose money FX trading.  

FX trading is, in the simplest possible sense, the process of buying and selling different currencies in the hopes of making a profit.  

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free
https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

There are many different currencies around the world, with varying exchange rates and values. 

Some of the most commonly known currencies include the United States dollar (USD), the Euro (EUR), the British pound (GBP), the Japanese yen (JPY), the Chinese yuan (CNY), the Canadian dollar (CAD), the Australian dollar (AUD), the Swiss franc (CHF), and the Indian rupee (INR), among others. 

Each currency has its unique symbol and code and is used to facilitate trade and commerce within its respective country or region.

The value of one currency against another is determined by several different factors.  

A country's interest rates, economic position, and economic policies all help traders determine the value of a currency against its peers.  

However, while these factors do influence the value of the currency over the long term, in the short term, and I’m talking about hours and days here, the value of a currency is determined by market sentiment and news headlines. 

That’s what makes FX trading so challenging. The investment and trading environment can change in the blink of an eye causing potentially huge losses for traders.  

Another reason why FX trading can be so risky is the fact that traders usually have to use leverage

Traders often employ leverage to increase potential profits although this also increases potential losses.  

But before I take a deeper look at the risks of borrowing money to trade a volatile asset class, I think I first need to take a step back and explain how currency markets work. 

How does FX trading work?  

If you’ve been on holiday, you will know the basics of the FX market. If you want to spend money in another country, you will have to change your funds from pounds sterling to whichever currency it is you want to spend.  

If you go to a foreign exchange booth and change your pounds sterling for dollars, for example, you are effectively selling sterling to buy dollars – very similar to selling any other good or service.  

If I have £100 and want to change it to dollars I can offer to sell it to a buyer who is willing to sell me a different currency in return.  

This is how FX trading works on the global market, although on a much larger scale.  

Every day $7.5trn of currencies are bought and sold around the world. From individuals transferring money to go on holiday or sending money home to relatives, to private equity companies forking out billions to acquire a business in a different country, the basics of the process are the same.  

Foreign currency traders try to make money by buying a currency at one price and hoping to sell it back at a higher price.  

For example, if I go on holiday to the US and want some spending money, I would sell my pounds sterling to buy US dollars. At an exchange rate of £1 to $1.20 I could buy $120 with a sum of £100.  

If I don’t spend this money, I can change it back when I get home. But currency markets are constantly changing, and that’s where FX trading can be quite profitable.  

If the exchange rate moves when I’m away, from $1.20 to $1.18, when I try and sell my dollars back in the UK, they will buy £101.70, a profit of £1.70.  

The risks of FX trading

One of the main benefits of currency trading is the potential for high returns. Because currencies are constantly fluctuating in value, traders can profit from the difference between the buying and selling price of a currency pair. 

However, it is important to note that currency trading is not without risks. The market can be highly volatile, and traders must be prepared to manage their risk through proper money management and discipline.

On a day-to-day basis, the rate of exchange between one currency and another is nothing more than a reflection of market sentiment. As such, currencies can swing widely in value.  

But over the long term exchange rates are determined by multiple macroeconomic factors such as interest rates, economic growth, and a country's debt load. 

Foreign currency trading involves trying to capitalise on short-term market movements to make a profit and leverage is usually used to improve returns. 

Returning to my holiday example; a profit of £1.70 is far from enough to make a living. A more attractive profit might be more in the region of £1,700, but to earn this I’d have to have sold £100,000 in the first place. 

That would be fine if I had the backing of one of the world's biggest banks, but for most, it’s an unattainable starting point. 

That’s where leverage comes into play. FX trading platforms usually offer punters leverage to increase profits and losses.  

One of the world’s largest trading platforms offers investors leverage of as much as 1:2000. That means for every £1 in an account a trader can play with £2,000 so I’d only need £50 to trade £100,000. 

This is where things can get dangerous. While leverage makes it easier to make money, it also makes it easier to lose money.  

Let's say I think the pound is going to fall in value against the dollar. To make money from this trade I would go “short” the pound against the dollar (GBP/USD).  

If a trader goes “long” they’re hoping the price will rise. If a trader wants to bet against a currency they will “short” it.  

If the exchange rate for the pound against the dollar is $1.20, and I want to go short sterling, I would purchase £1 for $1.20 in the hopes that the dollar appreciates. If it does, I can sell my dollars for pounds and earn a profit on the difference.  

And by using leverage I can improve my returns.  

So, if I use leverage of 1:2000 I can short the pound against the dollar using £100,000 (traded for $120,000) with a deposit of just £50.  

However, if the value of the pound against the dollar rose rather than fell I’d have to deal with some steep losses.  

If the exchange rate moved from $1.20 to $1.22 and I repurchased my pounds, I would receive £98,361. That would be a loss of £1,639 not only wiping out my deposit but also leaving me £1,589 in debt.  

Put another way, if a trade goes the wrong way, you can lose a lot of money very quickly when trying to trade FX.  

And the odds are stacked against the average trader.  

Around two-thirds of retail traders lose money. That means traders only have a 33% chance of success on average. Even this is not guaranteed.

To be successful in currency trading, traders must have a solid understanding of the market and the factors that affect currency prices. It is important to have a trading plan to stick to it, and to be disciplined in managing risk and emotions. Additionally, traders must stay up-to-date on global economic and political developments that may affect the market.

How to choose an FX broker 

If you want to get into FX trading, there are some things you should keep in mind when choosing who you trade with:

  • Only use a regulated broker. The FCA’s website has a list of those brokers registered with the regulator. The site also has a list of companies that are trading and not regulated. These should be avoided at all costs.
  • Never trade with more than you can afford to lose. You’ll likely lose all of your money so go into FX trading prepared for the worst.  
  • Just because you’re offered leverage it doesn't mean you should use it.   
  • You must know what you’re doing. The FX trading market is awash with scams and bad actors, that’s without taking into account the risks of trading with borrowed money in the first place.   
  • Consider the spread - the difference between the buying and selling price of a currency pair. The spread represents the profit margin for the broker, and traders must consider this when entering and exiting trades.  
  • Trading fees and commissions can eat into profits if not managed properly 
Rupert Hargreaves

Rupert was the former Deputy Digital Editor of MoneyWeek. He's an active investor and has always been fascinated by the world of business and investing. 

His style has been heavily influenced by US investors Warren Buffett and Philip Carret. He is always looking for high-quality growth opportunities trading at a reasonable price, preferring cash generative businesses with strong balance sheets over blue-sky growth stocks. 

Rupert has freelanced as a financial journalist for 10 years, writing for several UK and international publications aimed at a range of readers, from the first timer to experienced high net wealth individuals and fund managers. During this time he had developed a deep understanding of the financial markets and the factors that influence them. 

He has written for the Motley Fool, Gurufocus and ValueWalk among others. Rupert has also founded and managed several businesses, including New York-based hedge fund newsletter, Hidden Value Stocks, written over 20 ebooks and appeared as an expert commentator on the BBC World Service. 

He has achieved the CFA UK Certificate in Investment Management, Chartered Institute for Securities & Investment Investment Advice Diploma and Chartered Institute for Securities & Investment Private Client Investment Advice & Management (PCIAM) qualification. 

 

With contributions from